Commercial Notes: The ‘structured financing’ alternatives

Q: I am seeking to reduce my equity requirement for a new development project by adding a subordinate level of debt in addition to the primary mortgage. What are some of my alternatives?

A: Your goal is to seek what the mortgage banking industry commonly calls “structured financing.” Two of the most common methods through which structured financing is accomplished are mezzanine and preferred equity loans. There are numerous sources of capital that have made these two alternatives readily available to borrowers.

For example, let’s assume that the project being developed costs $5 million. The primary or senior mortgage lender is limiting the senior loan amount to 80 percent of appraised value, or 85 percent of cost, whichever is less. The appraised value of the completed project is over $6 million. Therefore, the senior loan amount is limited to 85 percent of cost, requiring $750,000. There is $250,000 available to invest in the project and a need to borrow the additional $500,000 to meet the senior lender’s requirements. Either a mezzanine or preferred equity loan can accomplish the structured financing goal.

Mezzanine debt is best defined as an additional layer or level of debt in addition and subordinate to the senior mortgage, which is not secured by the project itself, but by the developer’s equity interest in the project. A mezzanine lender will agree to lend the required subordinate debt secured by an assignment of the developer’s ownership equity interest in the project. If the mezzanine loan repayment terms are not met, the mezzanine lender can step into the developer’s shoes to satisfy repayment, converting the developer’s ownership interest to that of the mezzanine lender.

Mezzanine debt is much more expensive than senior debt and is generally available at an internal rate of return (IRR) of 12 to 15 percent. It sometimes will be priced at a greater cost predicated on the perceived project risk by the mezzanine lender. Often, the overall yield to the mezzanine lender will comprise up-front points, an interest rate charge that is paid during the term of the loan and an exit fee when the loan is repaid. A mezzanine loan usually carries a very definitive time line for repayment.

Under the preferred equity alternative, a lender receives yield consisting of an agreed-upon split of the project’s future cash flow (profit) plus a preferred interest rate paid on the equity invested.

The interest rate payment is preferential and must be paid before any cash flow or profits can be distributed to the developer. The preferred equity lender also is secured by the developer’s ownership equity. IRR requirements on preferred equity are usually greater than mezzanine debt, typically between 15 and 20 percent.

There are many alternatives to structuring the split on future cash flow for a preferred equity loan, but a widely accepted method is referred to as the “IRR lookback.” Assume that the preferred equity lender and the developer agree to a 17 percent IRR, with an interest pay rate of 8 percent and a 60 percent share of the cash flow.

Since the amount of cash flow received from the lender’s 60 percent share will fluctuate based on the project’s cash flow, there is a lookback provision guaranteeing the 17 percent IRR. Before the developer can take any additional cash flows other than the 40 percent split, the 17 percent IRR must be paid to the lender.

The major difference between the two alternatives is that mezzanine debt carries a higher interest payment schedule, not contingent on project cash flow. Preferred equity, on the other hand, allows a lower interest payment, but requires a split of the cash flow with the developer to arrive at the required yield.

The preferred equity structure typically allows the developer to receive earlier project cash flows in return for a greater yield to the lender.

David B. Eaton, president of Eaton Partners, Manchester, manages the firm’s Commercial Mortgage Group. Questions can be submitted to him at commercialnotes@eatonpartners.com.